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Monday, March 31, 2008

Thomas Kamps and Roland Ranz of indexplus give an overview of their index timing system in the Swiss newspaper Finanz und Wirtschaft (finance and economy). I like their concept. In the good times you are diversified, while in the bad times you seek shelter and watch the game from the side line. So this is an especially interesting time to watch their system in (in-)action:).

Saturday, March 29, 2008

Thursday, March 27, 2008

After reading Bernard Lunn's piece about Xing and LinkedIn I found another interesting article of his about Google's recent reaction towards a Microsoft Yahoo merger ("it is not good for the Internet"). "What pussies" a friend mine said (sorry;-).

But so far I thought Yahoo's most valuable asset is Yahoo Finance. Of course, they also have, Yahoo Mail. And together with Microsoft that makes 56% market share for the mail market (so they say). And it is kind of a hard question, what conveys more information about you, your web surfing habits or your email exchanges.

Anyway, now comes the other scary number that Bernard Lunn brought up, that email represents 49% of web page impressions! That makes 27% market share of all internet impressions. Wow.

* Email is 49% of Impressions. Portals and Search Engines is 10% by contrast. This is some free data from Nielsen-Netratings. click on Top Site Genres. * 56% is Microsoft and Yahoo combined market share of webmail. Gmail is down at 7%. This data is via Fred Wilson’s back of envelope calculations.

Yes both data sets can have a pretty wide margin of error, but even discounting that, this would be cause for worry.

Sure, in the early adopter world we live in, Gmail rocks and who would be seen dead with AOL or Hotmail? But that 50% market share for Microhoo is what you will see in the real world.

Hotmail has lagged terribly. Most people who used it would not return, I cannot imagine who would switch (an AOL user maybe) and most people already have email. So it is a lost cause. One major reason it lagged IMHO was Microsoft fear of cannibalizing Outlook. So they won’t offer the features that users want that both Google and Yahoo have been rushing to fill. Yahoo is reputed to have the most “Outlook-like” interface and that matters massively to people making the switch.

Microsoft will probably do the smart thing and let the Yahoo team run with email. Hotmail will die as a separate brand, eventually....The real battle of course remains around search within email and thus monetization. Google is better at relevant ads in Gmail because they have a better search engine. But if Microhoo gets its act together in search, they have the bigger content/audience to monetize. Technically improving search is not that hard. Microsoft have all the R&D money they need and, more importantly, every search start-up looking to exit to them. If you really can improve search you have one fat valuation offer coming down the pike!

Here is the really interesting bit. Improving ad relevance within email does not require any searching behavior change. That is worth repeating. Say after me, “if we have 56% of 49% we have something like 25% of ad impressions and all we need to do is serve relevant ads”. Come on developers, you can fix that, right? Page rank is not relevant. Getting people to switch from Google to another search engine is not required....However email is not just fodder for search it is the key to ad relevance, via the social graph. As Fred Wilson puts it, email is “the biggest social graph“.

Yes, the graph, who is connected to whom, that is indeed valuable. But the content of the mail is also, hmm, private and personal?! Everyone surfs the web, but does everyone publish there? Out in the open? Hardly. Only a minority publishes anything. But every working citizen has an email account and will write job related and private emails. Do people write everything they think in emails. Unlikely, but who would be comfortable if their mailbox would leak to the public:).

Another point, each mail has at least two parties involved. So with 10% market share of mail boxes you might actually cover twice as much percentage wise of the email universe. That doesn't help for serving ads, but, it helps building intelligence about what is going on out there and optimizing the algos. Again, it is a hard question what is more important, knowing what people search and surf on the web, or what they write in their personal email. With 56% email market share, Microhoo might actually know about maybe something like 70-80% of all mails?!

But then, who ever is in second place might just go to the NSA for a flat copy of it all in exchange for potentially better technology to snoop through it all:o).

Xing has twice as many page impressions as LinkedIn!!! Source comScore via the annual report. LinkedIn might have 4 times as many users. Still, I think Xing is way more interesting to browse around in and to use than LinkedIn.

But, growth in page impressions has not kept up with member growth, from 1.67 billion to 2.37 billion (42%).

Average minutes per visitor: 27.3 (9.43 for LinkedIn), 44.0 in Germany!

"The extension of the XING development architecture to include the web development framework Ruby-on-Rails proved to be a major factor of success in 2007 for scaling the development process. In this way, XING has taken one step closer to its long-term objective of service-oriented architecture. The functionalities such as Marketplace, PremiumWorld, etc., are already running productively on Ruby-on-Rails."

XING has 25 developers (not sure about contractors).

"epublica GmbH, Hamburg, which has developed the software for the XING platform and which is a shareholder of XING AG, provided services in the amount of € 2,127 thousand in the year under review (previous year: € 757 thousand). As of December 31, 2007, liabilities attributable to these services amounted to € 154 thousand (previous year: € 0)."

Wednesday, March 26, 2008

We made one large sale last year. In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value; the price of oil had climbed significantly, and PetroChina's management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies.

...However, if you are like me and think the bull market in commodities (including energy) has a lot of time left to go which could push crude oil to $150 or more in coming years, then yes, Buffett left a lot of money on the table that investors can now take for themselves. After all, PTR trades at $122 per share right now, about 80% below Buffett's own fair value calculation if you believe oil prices stay elevated long term.

Jesse Eisinger sees some red flags in the latest Lehman income statement as well as in its balance sheet in The Debt Shuffle.

Among them:

Lehman reaped substantial earnings gains because investors thought it is more likely to go bankrupt.

For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilties fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million.

Lehman and all the other investment banks are following the accounting rules on this, but that $600 million is hardly the stuff of quality earnings. Indeed, Bernstein’s Hintz called the bank’s earnings quality “weak.”

Sunday, March 23, 2008

In "The Little Book of Value Investing" Christopher H. Browne has a small section with remarks about L&S. Well, with L&S he means the Swiss company Lindt and Sprüngli. While the Lindt chocolate bars (and right now the easter bunny) are exported to or produced in many countries and especially popular in Germany, their Sprüngli stores are local and mainly centered in and around Zurich.Their reason to stay local was that in order to keep the quality high the products had to be fresh and produced locally and therefore they did not want to expand further away. Nevertheless their stores are all over the place in town and when it comes to chocolate in Switzerland, they are the number one brand here (well, not that they have no competition, you can go in other stores here and pay up to USD 10 for a 100g bar). Their main store with a big Caffee shop is at the heart of the city, at Paradeplatz, accross the two big Swiss bank main buildings, where Credit Suisse has its head quarter and UBS sees to its rich private banking clients.

Now let's see what Christopher H. Browne from Tweedy, Browne fame has to say about "L&S":

Another example from about the same time was Lindt and Sprungli (L&S), a Swiss candy company. Lindt makes expensive chocolates and has a great brand name. It was and is highly profitable. When we ran across Lindt and Sprungli, it was selling for 10 times reported earnings. That was pretty cheap especially since U.S. companies had recently bought another Swiss candy company and one in Norway for more than 20 times earnings. L&S was cheap for two reasons. The Swiss stock market was down because inflation had risen to an unheard of rate of 3.5 percent. The Swiss are buggo on inflation, which may help explain why they have one of the strongest currencies in the world. And Herr Sprungli had recently divorced his wife and remarried a Scientologist follower of L. Ron Hubbard. This had spooked the Swiss stock market for fear that the new Frau Sprungli might be appointed to the board of the company. A Swiss banker friend of ours told us that the former Frau Sprungli and her children had more stock in the company than her former husband, and she had told him that if he put his new wife on the board of directors, she would fire him. The Swiss are very pragmatic.

Apart from the gossip, he gives some insight into the financial numbers from a point in time that I guess is located more on the left site of this chart then the right one:

As we pursued our due diligence of the company, we saw that in addition to selling at 10 times earnings, L&S was selling at only 3.5 times cash flow. Cash flow is pre-tax, pre-interest expense earnings plus noncash charges for depreciation of fixed assets like factories and machinery. This is the money a company throws off before the tax man takes his share. Something did not compute. This was too cheap. Companies are allowed to depreciate their investments in fixed assets like factories and machinery on the theory that they wear out and the company will have to build new factories and buy new machinery over time. The number of years you can use to depreciate factories and machinery is usually dictated by government tax authorities. Switzerland is different. The companies choose their depreciation schedule. By dividing the depreciation of L&S into its fixed assets, the value of its factories and machinery, it looked like its depreciation schedule was about 26 months. Now, Switzerland is not Burma. The factories are not built of bamboo. More likely, a Swiss factory could withstand anything short of a direct nuclear hit. When we asked about this, we were told that Herr Sprungli was a very conservative man. When we made an adjustment to the rate of depreciation, L&S was selling for only 7.5 times earnings. When similar companies were bought for 20 times earnings or more, L&S looked pretty cheap.

Just for the record, official 2007 income numbers let Lindt & Srpüngli trade with a P/E of 30. At the moment, Google looks slightly cheaper.

Saturday, March 22, 2008

On 2008-03-17 UBS has been the worst performing stock on the Swiss stock market since the beginning of 2008. And this out of 233 listed stocks. Since then they recovered a bit and climbed one rank up to position 232!

Monday, March 17, 2008

This gave me reason to go back and to extract all his statements from the letters to shareholders back till 2002 that talk about derivatives in one form or another and to put it all here in one place. Actually, I have left out everything related to options and CEO compensation. That might be even a bigger post.

Of course, it is especially interesting in the light of the recent sub-prime/credit crisis (Bear Stearns just down, UBS to be split up?! Who knows what we will call it when it will be all over). Something else he only said in interviews (he called it madness before here), but is maybe more to the point than anything else he wrote, is this excerpt:

BUFFETT: But it shows you--when things get that complex, you're going to have a lot of problems. And CDO squared--I figured out, on a CDO squared you had to read 750,000 pages to understand the instruments that were underneath it.

QUICK: Oh, my gosh.

BUFFETT: Yeah. Well, you start with the RMB, that's the residential mortgage-backed securities, and that would have 30 tranches. And then you'd take--and that would be a 300-page document--you'd take a tranche from each one of that and create a CDO, 50 of those times three--300, you know, it becomes 15,000. Then you take a CDO squared with 50 more, and now you're up to 750,000 pages.

QUICK: You have to read through it.

BUFFETT: And the mind can't comprehend that.

As mentioned above, "it's madness".

Now, if you plan to read it all in chronological order, you might start from the bottom.

2007 letter:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

2006 letter:

I should mention that all of the direct currency profits we have realized have come from forward contracts, which are derivatives, and that we have entered into other types of derivatives contracts as well. That may seem odd, since you know of our expensive experience in unwinding the derivatives book at Gen Re and also have heard me talk of the systemic problems that could result from the enormous growth in the use of derivatives. Why, you may wonder, are we fooling around with such potentially toxic material?

The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts – few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk. So far, these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I’ve itemized from forward foreign-exchange contracts). Though we will experience losses from time to time, we are likely to continue to earn – overall – significant profits from mispriced derivatives.

2005 letter:

Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation-conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

2004 letter:

The wind-down of Gen Re Securities continues. We decided to exit this derivative operation three years ago, but getting out is easier said than done. Though derivative instruments are purported to be highly liquid – and though we have had the benefit of a benign market while liquidating ours – we still had 2,890 contracts outstanding at yearend, down from 23,218 at the peak. Like Hell, derivative trading is easy to enter but difficult to leave. (Other similarities come to mind as well.)

Gen Re’s derivative contracts have always been required to be marked to market, and I believe the company’s management conscientiously tried to make realistic “marks.” The market prices of derivatives, however, can be very fuzzy in a world in which settlement of a transaction is sometimes decades away and often involves multiple variables as well. In the interim the marks influence the managerial and trading bonuses that are paid annually. It’s small wonder that phantom profits are often recorded.

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of the earning power of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

2003 letter:

A far less pleasant unwinding operation is taking place at Gen Re Securities, the trading and derivatives operation we inherited when we purchased General Reinsurance.

When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn’t pronounce, much less creditworthiness I could evaluate). Since then, the unit’s managers have been skillful and diligent in unwinding positions. Yet, at yearend – nearly two years later – we still had 7,580 tickets outstanding with 453 counterparties. (As the country song laments, “How can I miss you if you won’t go away?”)

The shrinking of this business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’ve had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously.

If our derivatives experience – and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, “Ignorance more frequently begets confidence than does knowledge.”

* * * * * * * * * * * *

And now it’s confession time: I’m sure I could have saved you $100 million or so, pre-tax, if I had acted more promptly to shut down Gen Re Securities. Both Charlie and I knew at the time of the General Reinsurance merger that its derivatives business was unattractive. Reported profits struck us as illusory, and we felt that the business carried sizable risks that could not effectively be measured or limited. Moreover, we knew that any major problems the operation might experience would likely correlate with troubles in the financial or insurance world that would affect Berkshire elsewhere. In other words, if the derivatives business were ever to need shoring up, it would commandeer the capital and credit of Berkshire at just the time we could otherwise deploy those resources to huge advantage. (A historical note: We had just such an experience in 1974 when we were the victim of a major insurance fraud. We could not determine for some time how much the fraud would ultimately cost us and therefore kept more funds in cash-equivalents than we normally would have. Absent this precaution, we would have made larger purchases of stocks that were then extraordinarily cheap.)

Charlie would have moved swiftly to close down Gen Re Securities – no question about that. I, however, dithered. As a consequence, our shareholders are paying a far higher price than was necessary to exit this business.

2002 letter:

On the minus side, the Finance line also includes the operations of General Re Securities, a derivatives and trading business. This entity lost $173 million pre-tax last year, a result that, in part, is a belated acknowledgment of faulty, albeit standard, accounting it used in earlier periods. Derivatives, in fact, deserve an extensive look, both in respect to the accounting their users employ and to the problems they may pose for both individual companies and our economy.

Derivatives

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

UBS AG, Europe's biggest bank by assets, fell the most in more than nine years in Swiss trading after reports that the company may cut as many as 8,000 jobs, propose a new capital increase and sell businesses.

UBS fell 3.26 francs, or 11 percent, to 25.18 francs by 11:28 a.m. in Zurich. If the shares close at this price, it would be the biggest drop since Sept. 30, 1998. Credit-default swaps on UBS jumped 25 basis points to 235, according to Deutsche Bank AG. ...Bear Stearns Cos. had to sell itself to JPMorgan Chase & Co. for $240 million, about 90 percent less than its value last week, after clients, alarmed by speculation about a cash shortage, withdrew $17 billion in two days.

We don’t know for 100% sure if it’s true that the building housing Bear Stearns is worth three times the bank’s total equity (as the following contends). But we do know that also-ran social networking site Bebo sold for $850 million just before Bear did. And that that is sad.

Friday, March 07, 2008

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion....Second, beginning today, the Federal Reserve will initiate a series of term repurchase transactions that are expected to cumulate to $100 billion. These transactions will be conducted as 28-day term repurchase (RP) agreements in which primary dealers may elect to deliver as collateral any of the types of securities--Treasury, agency debt, or agency mortgage-backed securities--that are eligible as collateral in conventional open market operations.

Tuesday, March 04, 2008

and last week we had some deleveraging of the municipal bond market, which is not a market you would normally expect to get hit by that sort of thing. But we've had it--they really haven't deleveraged as much as they wanted, things like leveraged loans at the banks. They've been trying to sell them, and they haven't found the levels yet at which they'll move. But that's--you got a very leveraged world, and it's getting somewhat deleveraged.

And unfortunately for the people that are deleveraging, it was leveraged at crazy valuations in many cases. So people that are out--have been out on a limb financially are having the limb sawed off. ...Some they're calling at 75 cents on the dollar. But--and we'll buy some, at some point. But there's a--there's a lot of merchandise out there that people are getting margin calls on, and they're not the small guy getting a margin call on stocks. These are big guys getting calls on billions and billions of dollars of fixed income positions....Well, we heard from them, but we tossed our hat in the ring, and they tossed the hat back. But fortunately--it's been fortunate for us, because we've been writing business that they insured, and we're getting a far better rate than we offered to take it over from them. So here--we've written 206 transactions in the last three weeks, and we have been paid an average of 3 1/2 percent to take on business that they wrote at 1 percent. But we don't pay until they go broke. So in effect, the municipality has to quit paying, and over here I've got the bond insurers. And it's just--it's the three you named plus a few others. And they have to go broke, and then we pay. So we're getting paid 3 1/2 percent to be in a secondary position when we offered to do it for 1 1/2 percent in a primary position....Oh, no. We're not--no. These are all A-rated or better municipals insured--202 of the 206 are insured. And we've received $69 million of premiums for two billion of a par amount. The original insurer received about 20 million. And they're still primarily on the hook. So our price was all wrong....We--we'll give an offer good for a minute or something. We--there's no--we are not offering puts to the rest of the world for nothing. And a bid is a put as long as it's outstanding, and puts you're supposed to get paid for in this world. So we put them out for, you know, basically a minute or two. We want the fellow on the other end to be able and prepared to act, and we do not want him to use our price to out and shop with somebody else....I didn't see it--in '73 and '74, I didn't see how bad things were going to get. I kept buying more as I got worse, but I--if I'd seen in '73 what was going to happen in '74, I wouldn't have bought anything in '73. You can't predict. We don't try and time anything or predict. We just look for where there are good values, and if we find them, we buy them, and if we don't, we don't buy anything....But if they're looking [Obama or Clinton], one of them will probably be looking for a job here in a few weeks. I would be glad to hire either one of them. !...BUFFETT: Yeah. I--overall in terms of that--I think everybody should read Jack Bogle's book. Low--what you really want to do is you want to own an American industry which is going to do fine over time, but you want to make sure you don't put all your money in at once because you might pick just the wrong point.

QUICK: Mm-hmm.

BUFFETT: But if you buy in over time into a wonderful business, which is American industry, and you make sure you don't go in at just the wrong times, when people get excited, and you get to keep your costs low, you're going--you're going to beat 90 percent of the people because they're going to run up unnecessary costs....BUFFETT: Well, you know, the ways you get into trouble in markets is doing things you don't understand, and then doing them with a lot of borrowed money. And derivatives combine those things. And--but the really important illustration that has never gotten picked up on much was that a couple of years ago Freddie and Fannie got into big trouble, billions and billions and billions of dollars of--that they had to restate. Now, Freddie and Fannie had auditors like everybody else, but they also had a government agency called OFHEO that had 200 people in it whose sole job was to oversee Freddie and Fannie. Two hundred people going to work every day, and those people did not pick up at all on all of these problems that Freddie and Fannie had. I mean, they were looking at complex financial instruments, you know, all kinds of swaptions and all that sort of thing. The auditors didn't pick up on it, but more important, 200 full-time--they didn't have to think about General Motors, they didn't have to think about AT&T. They had two companies to think about. And they issued a report later on telling about the failing of all--everybody else.

QUICK: Mm-hmm.

BUFFETT: But it shows you--when things get that complex, you're going to have a lot of problems. And CDO squared--I figured out, on a CDO squared you had to read 750,000 pages to understand the instruments that were underneath it.

QUICK: Oh, my gosh.

BUFFETT: Yeah. Well, you start with the RMB, that's the residential mortgage-backed securities, and that would have 30 tranches. And then you'd take--and that would be a 300-page document--you'd take a tranche from each one of that and create a CDO, 50 of those times three--300, you know, it becomes 15,000. Then you take a CDO squared with 50 more, and now you're up to 750,000 pages.

QUICK: You have to read through it.

BUFFETT: And the mind can't comprehend that. What people did comprehend was that the fees were terrific in selling them to the people....I'm only 99 percent Berkshire myself, so I never go 100 percent. Well, I think if you buy equities across the board, which means an index fund, and if you do it over time so that you don't put all your money at the wrong time, and it's a low cost index fund, that's probably the best investment that most people could make. Mm-hmm....Well, it wasn't a mistake at the price we bought it. But in terms of the--the intrinsic business value of Moody's decreased last year. I mean, Wells Fargo stock was down last year. I don't think the intrinsic business value shrunk. In fact, I said I thought it probably increased a touch. And there's a lot of companies whose stock went down where the intrinsic business value did not go down, or maybe went up. But I--our holding a Moody's, which is a significant holding, they're--I don't think there's any question that the intrinsic business value of a Moody's shrunk last year, just as McGraw-Hill owns S&P and the S&P component of McGraw-Hill, it--they have less of a moat around them and they're going to be affected for a long time by the experience of the last couple years....Yeah, it's me that makes the decision. And I would say this: with drug companies, I feel I know less specifically about a given company's future than I might if I were buying a candy company or whatever it might be, because it's very difficult to say who will have the winners five or six years from now. I think--I think if you buy drug companies that you probably want to buy those with--that--you probably want to buy them somewhat across the board. You know, it would be hard for me to make a bet on any specific company based on something that was in the pipeline that might come out in two or three years. You know the ones that are coming off protection, so you'll see--in a Sanofi, you'll see certain things that are going to cause the earnings to go down, and what's going--what will cause the earnings to go up is in the pipeline, you're sort of guessing at. If you have a group of them, I think you'll probably do OK if you buy in at sort of a multiple for the group. And actually, the drug companies have gotten in some cases quite a bit cheaper in recent years.

KERNEN: So we shouldn't be surprised to see you--then it wasn't that you were picking nondomestic drug companies, you might end up with a stake in one of the domestics at some point.

BUFFETT: Yeah, very easily. And, of course, the domestics have a lot of earnings coming from abroad, too. I do like earnings coming from abroad better than earnings coming from the United States. So if they're doing business--but most of them are doing business all over the world, so there's not a huge difference in that. We own some Johnson & Johnson and, you know, half the earnings, roughly, will come from abroad. And we think we probably have some currency play. We've already had some, but it hasn't been reflected that much in the stock. But there will be a J&J, a Sanofi, you name it, they will earn a lot of money abroad and they'll come up with some drugs that surprise you and they'll have plenty of them that are earning a lot of money now that'll--won't be earning any money for them or anything to speak of 10 years from now....Yeah. You can get rail volume--you can--you can go to the Internet and every week get car loadings as to each railroad. And so I click on there every week and look at--look at car loadings. Car loadings were down last year,...I would tell people if they worry what the market does on any given day, they shouldn't be buying stocks.